Take a High-Yield Backtest

As long as I'm in the mood to torture data and mangle spreadsheets, I decided to run one more backtest before moving on to my regular activities. One of the more pressing needs for investors is the need to gain income from their investments. But yield-chasing can be dangerous, so I decided to test some income investing ideas that focus on unconventional higher-yielding stocks to see if I could find any helpful information and potential answers.

The first discovery is that uninformed yield-chasing is extraordinarily dangerous. Simply buying stock with high double-digit yields can be disastrous for your portfolio. After factoring in dividends, however, the strategy basically breaks even over the past 25 years, but the loss years are dramatic. There are several periods with losses in excess of 20%. There are two occasions where losses topped 50% for the year. Many high-yielding stocks are dangerous, and the data reinforce this fact. Buying the highest-yielding securities is a bad idea and it will cost you enormous amounts of money.

I tried many variables to improve the results and discovered that adding a return on equity threshold to my search improved the results. By searching for stocks with high yields, positive earnings and a return on equity of more than 10%, results were much better: It equaled the market's appreciation before dividends and eliminated most of the double-digit loss years. Only 2008 was a horrid year, but that was true regardless of the investment approach. Even though this approach lost money, it still lost less than investors in the broader indices did. The screen also got rid of the worst possible investment result, as there were no strings of consecutive double-digit losses. After adding back dividends, the screen produced no consecutive loss year during the test period of 25 years.

It's a small shopping list when to use this approach now. Only 39 stocks have a yield above 8%, positive earnings and a high return on equity. The group most represented is mortgage real estate investment trusts. Although the sector is not without risk, I like it for long-term unconventional yield investors. The four on the list that I favor are Dynex Capital (DX), Hatteras Financial (HTS), Invesco Mortgage (IVR) and Two Harbors (TWO). These REITs have seen insider buying in recent months. I prefer to buy them at a discount to net asset value, and they currently trade at a small premium. Patient investors might wait for a pullback in the group to initiate positions.

An old favorite, Prospect Capital (PSEC), has seen its share price slip in the wake of an equity offering last month. The business development company has done several secondary offerings since its IPO to gain additional cash to deploy in financing middle market companies and private equity sponsored firms. The firm invests across a wide range of industries but favors industrial and energy related companies. The shares trade right at net asset value and yield a little over 11% at the current price.

Backtesting is not a guarantee of future performance, but we can build a portfolio of unconventional yield stocks that provide needed income and long-term appreciation potential. Focusing on companies that are profitable and have high returns on shareholders equity appears to give us a long-term edge as income investors. I cannot emphasize enough the need to stay small at all times in this sector. The more stocks you have spread across more industries in an unconventional yield portfolio, the better off you will be. Move slowly and take what the market gives you, rather than forcing your purchases.